Altair Insight: Holding Up (3Q19) – Quarterly Market Review
When the Rolling Stones kicked off their North American tour last June in Chicago, cardiologists were on standby at Soldier Field. The precaution stemmed from 75-year-old frontman Mick Jagger’s heart valve replacement surgery just 11 weeks earlier, but the symbolism involving the venerable rockers was apt.
Defying expectations (and perhaps spectators’ trepidations), the street fighting septuagenarian showed little sign of slowing down – prancing, strutting and belting out 20 songs in a high-octane two-hour concert. How have the Stones held up this well as performers for so many years? How much longer can they possibly go on?
We know, it’s only rock ‘n’ roll. But we see parallels to questions about the longest-running business expansion and bull market in U.S. history.
Uncertainty may seem particularly high at the moment, with multiple threats to the economy’s health looming: the U.S.-China trade war, weakening global growth, Brexit, Middle East tensions, impeachment proceedings, a manufacturing slump and a temporary yield curve inversion. Recent turbulence has crimped some areas of the market, including small caps and international stocks. Yet the broad U.S. market hovers around its all-time high, bond investors have enjoyed solid gains and the economy continues to deliver steady if unspectacular growth, thanks to the strength of household spending and the labor market.
We do not view these risks lightly. Just as the Rolling Stones’ 57-year run will one day end (time waits for no one), so too will this economic cycle. We do not recommend that clients increase the amount of risk in their portfolios beyond their current (neutral) asset allocation targets.
Yet we maintain a positive market outlook overall given the countervailing forces that we believe can offset most of the above risks. We think U.S.-China trade tensions will ease as the two sides work toward finalizing a deal. We view a recession as unlikely in the next 12 months. And we anticipate additional monetary easing by the Federal Reserve that will help boost the global economy and markets. For now, we still believe that time is on our side.
Our further thoughts on five defining themes of the quarter:
1. The provisional trade “deal” would leave most issues unresolved but shows both sides’ desire to ultimately deescalate the conflict.
Trick or truce?
The “Phase 1” trade agreement announced by the White House on October 11th has inspired many questions and much skepticism, justifiably so. It comes after months of markets yo-yoing up and down on every perceived hint of a potential deal or breakdown. The latest proclaimed advancement came with unspecified terms, making it hard to assess its significance. Beijing termed it “progress” rather than an actual deal and signaled more talks are needed, meaning the preliminary agreement will likely take at least several more weeks to iron out before anything is signed. In the meantime, tariff increases threatened for December still loom.
Even if agreed to as presented, Phase 1 reportedly does little to address the deeper issues of intellectual property, technology transfer and industrial strategy that are at the heart of the year-and-a-half-old conflict. Hard negotiations lie ahead, along with more acrimony and uncertainty, before any truly comprehensive deal could be nailed down.
All that said, it represents a reversal of the trend toward escalating tariffs and the best evidence since May that a meaningful deal of some kind is in the works.
Both Donald Trump and Xi Jinping have stronger incentives to finalize an agreement the longer the trade war drags on, for different reasons. President Trump needs to show a victory or at least a trade accomplishment before his 2020 campaign fully gears up. A deal that helps boost sagging business confidence and stimulates the stock market would greatly strengthen his re-election chances. The need to strike a deal would become urgent if a recession were to appear imminent: No U.S. president since Calvin Coolidge has won reelection when a recession occurred within the two years before the election.
President Xi, for his part, would like to shore up his country’s decelerating economy as it continues to suffer from a drop in trade, with exports to the United States down 22% during the trade war. Even China’s purchase of up to $50 billion worth of U.S. agricultural goods, as President Trump suggested under the partial deal, would not stop its economy from slowing further. It would make little difference in the huge U.S. trade deficit with China. The renminbi, too, is under pressure.
Resolution of the trade war’s most contentious issues may be unlikely. However, a series of partial deals would be a welcome development as any agreement would help shore up business confidence and inspire more capital spending.
2. U.S. consumers continue to demonstrate their capability of handling the heavy lifting for both the American and global economies.
Much is made of consumers’ key role in the health of the U.S. economy, and rightly so. Consumer spending represents close to 70% of gross domestic product. Yet it also is larger than the entire Chinese economy, accounting for 17% of global GDP.
This is a hefty burden to carry (see our quarterly cartoon) and we are watching closely for data suggesting the consumer is buckling under the weight. Despite signs of wobbling over the summer when a spike in trade and tariff tensions coincided with a pullback in spending growth, consumer strength remains solid. Assuming the recent moves toward de-escalation of the trade war hold and central banks remain accommodative, we see limited danger signals that are likely to trigger a U.S. or global recession within the next 12 months.
The drop in U.S. business confidence keeps our outlook cautious, however, as it has begun to have consequences that raise the risk of an increased slowdown if trade concerns deepen.
Manufacturing has sunk to its lowest level in more than a decade and may worsen as trade fluctuates. The service sector is at its weakest in three years. Goods-producing companies account for 44% of the S&P 500 by market cap, meaning financial markets are vulnerable to these declines even if they are outweighed by consumers’ clout. Corporate earnings have stagnated on a year-over-year basis as firms feel a squeeze from tariffs and declining trade, although third-quarter results got off to a solid start this earnings season.
We anticipate improvement in these categories in 2020 if a trade deal comes to fruition, as we expect. In the meantime, weaknesses are being partially offset by a housing market recovery, record-low unemployment, low inflation and job growth that has decelerated but remains solid. Leading economic indicators have slowed but point overall to steady, continued growth.
This past summer’s rise of short-term Treasury yields above longer-term ones – a yield curve inversion, historically a precursor to a recession in the next 12 to 24 months – provided a warning about rising risks. But the trend has reversed this fall with interest-rate cuts and with economic reports that show data less worrisome than before.
The world economy is at risk from ongoing trade war uncertainty that heightens concern about a possible global recession. Manufacturing and investment have slipped worldwide and the global trade flow has declined. Government bond yields are near historic lows in many advanced economies and well into negative territory in Europe, underscoring the lack of confidence in a quick recovery. The possibility of a Brexit shock still looms.
Growth appears to be accelerating in emerging economies, even with China struggling to maintain 6% annual growth. And widespread strength in rising household income, low unemployment and consumer spending supports forecasts that world GDP will soon rebound following this year’s slowdown.
Evidence points to both the U.S. and world economies softening but still on track to grow modestly into 2020.
3. The Fed has delivered on its word to act as needed; another 2019 rate cut will help.
The Federal Reserve has taken decisive steps in recent months in its monetary easing campaign to try to keep the economy and financial markets operating smoothly. We believe it is unlikely to stop with inflation low and economic growth restrained.
Most importantly, its first two interest-rate cuts since 2008 in July and September brought relief to investors worried about prospects of a recession. In a smaller adjustment in mid-October, the Fed began buying $60 billion of Treasury bills a month to address cash shortages that caused a recent spike in the overnight cost of borrowing, known as the “repo” market.
Will the next step be a return to quantitative easing after three rounds between 2008 and 2014 that ballooned its balance sheet to $4.5 trillion? Unless or until the economy deteriorates significantly, we do not think so. QE obviously looms as a possible last resort to try to stave off any approaching recession. But while previous doses ignited the stock market to a series of record highs, it is no silver bullet for investors to count on again.
Fed Chair Jerome Powell clearly believes that a continuation of loose monetary policy will not overheat the economy. In remarks to the National Association for Business Economics in October, he said: “This just feels very sustainable. There’s no aspect of the economy that is booming. … There’s no one sector like a housing bubble, there’s nothing like that.”
We take that as additional evidence of Powell’s intention to lower the federal funds rate further. The September Fed meeting revealed a more divided outlook than we have seen among the policymakers in years. However, Powell has pledged repeatedly that they will step in with more cuts if necessary and we believe they are still inclined to do so – if not at their October 29-30 meeting then in December.
We believe these Fed actions, including raising the balance sheet, should help sustain low-level economic growth.
It is not yet necessary for the Fed to take the extreme measures that the European Central Bank has taken in cutting interest rates deeper into negative territory and resuming QE in September. But the ECB’s actions should be welcome news for investors worried about Europe’s sagging growth and its drag on the global economy.
Not just the Fed and the ECB have become more dovish. A total of 16 global central banks lowered interest rates in the third quarter, with many more expected to do so by year’s end.
Underscoring central banks’ heightened activism, one of the rate-cutters, the Bank of Jamaica, even launched a campaign about the importance of low rates and inflation via a series of videos that are as cool and catchy as one might expect for the land of reggae. Excerpts: “We no want it too high / We no want it too low.” “No inflation monster / Shall prosper.” And “Keep de rates dem low, stable and intact / So de consumers can buy more good wit dem cash!”
We will not attempt to compete with what even the Wall Street Journal said may be the grooviest public-education campaign ever undertaken by a central bank. But in the spirit of Jamaica’s central bank, here is our outlook in brief (unaccompanied by music) for another Fed rate cut that should help support markets:
The economy’s “in a good place.”
Jay Powell says that’s the case.
But the Fed will cut rates
Since it’s good but not great
And inflation is still below pace.
4. Brief but sharp market shifts in September created uneven performance in some equity categories.
While the U.S. bull market in stocks endured in the third quarter as the large-cap S&P 500 Index continued its best start to a year in over two decades, a few surprising trends underneath the surface departed from recent patterns.
Indeed, large-cap indexes registered new all-time highs in July but then fell in August as a violent sector rotation into previously underperforming value sectors carried into September. While large caps continued to outperform smaller companies, defensive categories trounced cyclical names. These market shifts have led to uneven results of some asset classes and individual fund managers.
Underneath the hood of the market, the defensive sectors of utilities (+8.4%), REITs (+7.0%), and consumer staples (+5.4%) outperformed in the third quarter, benefiting from the demand for safe havens as well as from a steep decline in rates. On the other end of the performance spectrum were energy (-7.2%), health care (-2.7%) and materials (-0.7%). For all of 2019 through September, technology (+30%) remained the top performer, followed by REITs (+27%) and utilities (+22%).
In addition, within the technology sector (+3.3% in the third quarter), more aggressive growth stocks underperformed the broader growth market in the July-through-September period. Among them are tech giants that have powered the market for years: Facebook, Apple, Amazon, Netflix and Alphabet-owned Google (the FAANGs). Indeed, Netflix shed 27% in the quarter while Zillow fell 35%. Part of the suffering in the higher-growth end of the tech sector was due to the initial struggles of high-powered IPOs such as Lyft, Uber and Chewy, which collectively lost more than 30% during the quarter.
Value stocks enjoyed a renaissance in September, outperforming growth by 3.4% – one of their best relative performances in more than 10 years — though by quarter’s end growth still edged out value. We are reluctant to declare a secular style shift toward value at this point.
Overall, these idiosyncratic trends negatively affected some asset classes and fund managers. If the economy remains on an even keel and avoids recession in the next 12 months, as we expect, these shifts should be short-lived.
5. Impeachment is not an immediate threat to markets.
Financial markets’ performance during the prior impeachments of U.S. presidents is no blueprint for what to expect this time. If anything, history shows heightened uncertainty could come next for markets, with sharp swings possible in either direction.
Investors looking for lessons from the past would be better off heeding the old political campaign mantra, “It’s the economy, stupid.” Economic fundamentals, along with expected policy changes under any future administration, are likely to have a far greater influence on markets than the political drama of impeachment.
A look at markets during the previous presidential impeachments underscores that the economy and circumstances particular to those times mattered most.
The impeachment of Andrew Johnson in 1868 came at a time when price data was limited and markets were very different from today. Stocks outperformed when Johnson was acquitted while bonds rallied throughout the three-month impeachment process, according to economist Craig Botham of London-based Schroders, who authored a 2017 white paper on impeachment and the markets. But it is “highly debatable,” Botham concluded, whether that tells us anything about the contemporary market reaction to impeachment.
That leaves just the two 20th-century instances to analyze, and impeachment does not appear to have been the main driver of market movements in either one.
Richard Nixon: Markets performed miserably throughout the Nixon impeachment; the S&P 500 plummeted 26% between the October 1973 start of his inquiry and his August 1974 resignation. But economic pressures at the same time – the OPEC oil embargo, a sharp rise in interest rates by the Fed and a recession – are the likely culprits rather than the impeachment process.
Bill Clinton: The S&P 500 sank as much as 20% in the runup to Clinton’s impeachment proceedings beginning in October 1998, but the sell-off was triggered by a Russian currency meltdown and the near-collapse of the giant hedge fund Long-Term Capital Management. Then, helped by the Fed’s rate reduction, it rallied nearly 27% between the start of his inquiry and his acquittal four months later. Again, though, a major unrelated event – the technology-fueled bull market of the late ‘90s – was the spark.
An impeachment of President Trump by the House of Representatives can of course have two outcomes: conviction by the Senate or acquittal, and the latter currently appears much likelier given the requirement of a two-thirds super-majority in the Republican-controlled Senate for conviction. From a pure market standpoint, this would likely cause far less disruption than a conviction given Wall Street’s abhorrence of uncertainty. Political news headlines are still likely to cause occasional market gyrations throughout this period, although such movements are likely to be secondary to any meaningful trends involving the trade war or the economy.
The state of the economy remains the best gauge for how markets are likely to perform over the next 12 months. We still believe a recession during this period is unlikely.
Recent movement toward a partial trade deal, while preliminary, is evidence the U.S. and China are both working toward an agreement. While more bouts of trade tension are likely, we expect an accord of some kind to be reached in the next 12 months.
Weak global growth because of the trade war and flagging confidence is an overhang for markets. A trade agreement would help ensure the world economy does not sink into recession.
The recent shift by global central banks to easier monetary policies should help extend this business cycle. We expect the Federal Reserve, which has begun expanding its balance sheet again, to make another interest-rate cut by year-end.
We continue to see opportunities in equities, particularly in small-cap and emerging-market stocks, even with certain indexes near record highs. Internationally, the rise in the dollar has gone on longer than we expected and an inevitable pause or reversal will boost non-U.S. stocks, where valuations remain attractive.
Bond yields have climbed up off near-historic August lows but are unlikely to rise sharply again with much of the world offering negative yields for their government bonds, as global growth and inflation remain subdued. Bonds have returned strong gains this year and continue to offer portfolio diversification.
Threatened new tariffs and the trade war’s spreading impact made for a tumultuous summer and early fall for investors. Two rate cuts by a Federal Reserve concerned about slowing growth helped steer the main U.S. stocks gauge back into positive territory in September and the best year-to-date gain (20.6%) through three quarters in 22 years. The 1.8% quarterly gain for the iShares S&P 500 ETF was the smallest this year, however, and other areas of the U.S. market were mixed.
Smaller companies’ stocks gave ground amid recession worries which faded as more positive economic data emerged by quarter’s end. The iShares Russell 2000 ETF dipped 2.3% over the three months to reduce its year-to-date gain to 14.1%.
Many cyclical and tech stocks struggled as investors shied away from higher growth sectors such as communications services and technology in favor of traditional value sectors like utilities and real estate, which gained 9.2% and 7.7% respectively to lead all S&P 500 sectors. Energy was the big loser in the quarter at minus 6.3% and joined health care as the year’s two sector laggards with only single-digit gains through nine months. Tech still leads the way for the year with a 31.2% advance.
A strong September by value stocks (3.7% rise for the benchmark) stirred buzz on Wall Street, but they do not threaten growth stocks’ long run of dominance just yet. The iShares Russell 1000 Value ETF still trailed its growth counterpart for the quarter (1.7% to 1.5%) and year to date (23.0% to 17.5%), although it did register a slight edge (4.5% to 3.8%) over its peer for the preceding 12 months. The differences were similar at smaller cap levels.
Non-U.S. stocks struggled to gain traction in the face of two big challenges: The slowing of global trade and growth because of the U.S.-China trade war and a jump in the dollar against other currencies. The result was their weakest quarter of the year; the iShares MSCI ACWI ex-U.S. ETF, a proxy for all foreign stocks, fell 1.5% to trim its 2019 gain to 11.7%.
After a fractional decline in the first half of the year, the greenback surged 3.4% to its highest level since May 2017. Much of the gain was due to the fall of the euro on concerns about eurozone growth and Germany’s economy sliding to the brink of recession. The widening of the gap between U.S. government bond yields and the negative yields in Japan, Germany and elsewhere also made the dollar a more attractive asset.
The iShares MSCI EAFE ETF, a benchmark for the stocks of Europe, Australasia and the Far East, declined 0.8% and was up 13.3% for the year. Absent the dollar’s impact, the index was up 1.8% and 16.2%, respectively. Emerging markets were hit harder, with the iShares MSCI Emerging Markets ETF pulling back 4.8% for a year-to-date gain of 5.4%.
The worst performer among the world’s major stock markets was Hong Kong’s Hang Seng Index, which fell 8.6% in its worst quarter in four years as investors lost confidence amid the anti-Beijing protests and the trade war. China’s Shanghai Composite Index sank 2.5%. Markets in Europe, Japan and the United Kingdom all posted low single-digit-percentage gains.
U.S. real estate investment trusts extended their lead as the top-performing asset class in 2019, adding 7.4% for a 28.1% return through three quarters. International REITs as benchmarked by the Vanguard Global ex-U.S. Real Estate Fund eked out a 0.1% gain for a year-to-date return of 13.4%.
Falling Treasury rates during the quarter acted as a catalyst for U.S. REITs. REITs often see short-term benefits when the government bond yields fall, as their high-dividend payouts make them relatively more attractive. REITs are required to pay out most of their net income as dividends to shareholders in order to avoid double taxation at the corporate and personal levels.
Commodities were hurt by weakening global growth and the rising dollar, which tends to drive down foreign demand for dollar-denominated assets such as gold and crude oil. The iPath Bloomberg Commodity Total Return ETN gave back nearly half of its first-half gain, retreating 2.0% to trim its 2019 return to 2.7%.
Oil prices were particularly volatile. After surging following
the drone and missile attacks on Saudi Arabia’s energy infrastructure, U.S. crude retrenched and ended up declining 6.5% for the quarter. Gold benefited from worries about the global economy, reaching its highest level in six years and posting a 5% gain from July through September. Palladium, used in catalytic converters to reduce vehicle exhaust, rose 9% in September alone and was up 33% in 2019 amid tight supply and increasing demand from automakers seeking to meet tightening emission standards in Europe and China.
Hedged and opportunistic strategies collectively registered modest gains for the quarter, roughly mirroring those of U.S. large-cap stocks.
The HFRX Global Index, a benchmark representing the entire hedge fund universe, followed up its best first-half return since 2009 with a 1.6% rise for a year-to-date increase of 5.9%. The HFRX Equity Hedge Index, which tracks both long and short equity-related strategies, matched the S&P 500 for the quarter with a 1.8% advance to nudge its year-to-date gain to 7.9%.
The Fed’s shift to a more accommodative monetary policy and growing anxiety about the global economy combined to produce a turbulent but positive quarter for bond investors.
Yields sank sharply, with prices jumping correspondingly higher; the benchmark U.S. 10-year Treasury note fell from 2.0% at the start of the quarter to a three-year low of 1.4% in September before rebounding. For the first quarter since 2009, the yield on the 30-year U.S. Treasury bond fell below dividend yields on the S&P 500.
Another first in a decade: The yield on the U.S. 10-year note fell temporarily below that of the two-year note, historically a precursor to a recession in the next two years.
Taxable bonds were particularly solid, delivering a 2.3% gain for the Vanguard Total Bond Market ETF, which hit the year’s three-quarters mark with an 8.6% increase. Tax-exempt municipal bonds advanced modestly; Altair’s investable benchmark for municipal bonds gained 0.8% for a 5.0% return for the year through September.
The material shown is for informational purposes only. Past performance is not indicative of future performance, and all investments are subject to the risk of loss. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, no entity is able to accurately and consistently predict future market activities. Information presented herein may incorporate Altair Advisers’ opinions as of the date of this publication, is subject to change without notice and should not be considered as a solicitation to buy or sell any security. While efforts are made to ensure information contained herein is accurate, Altair Advisers cannot guarantee the accuracy of all such information presented. Material contained in this publication should not be construed as accounting, legal, or tax advice.